SUPPLIER AND TECHNOFIN®

Covered warrants in context – A global perspective

With the exception of the US and the UK there are securitised derivative markets in all the major capital markets around the world.

In Europe the ‘big 3’ are Germany, Italy and Switzerland – but there are also markets in France, Spain, Scandinavia, Portugal, Holland and Belgium. Further afield, there are established markets in Japan, Hong Kong, Singapore, Australia, South Africa and Canada.

In Europe these products have been in existence since the late 80’s and have proved enormously popular.

In July 2002 alone the combined premium turnover in these products in Germany, Italy and Switzerland was $8.3bn generated by over
1.6 million trades

The relatively small average trade size of $5,000 reflects the fact that the majority of this activity originates from private client investors rather than institutions.

Up to now the regulatory framework within the UK has precluded private clients from trading these products. However, that all changed when a new set of rules issued by the FSA came into effect providing guidelines for the listing of products and a conduct of business regime for participating firms and individuals.

What do we mean by ‘Securitised Derivatives’?

Securitised derivatives encompass three broad types of product– covered warrants, certificates and structured products. Covered warrants are securities that have similar economics to options – that is they confer on the holder, the right to buy or sell a certain underlying asset at a particular price within a specified timeframe.

Importantly, the price the investor pays for the warrant will be lower than that of the underlying share which gives investors the ability to gain leverage – that is earned potentially higher returns than they could through direct ownership of the underlying asset.

This leverage effect also increases the risk of the product, but in contrast to some vehicles an investor cannot lose more than their initial investment.

Unlike warrants, certificates have no leverage – in other words, their price tracks the performance of the underlying asset directly and as such offers a much lower risk investment.

A FTSE 100 certificate for example would give an investor a cost efficient means of buying a security whose return will track that of a diversified index. The final category of structured products contains any securitised derivatives that have more complex features.

This complexity may lie in the underlying asset – a custom basket of shares would be a classic example, or the payoff of the product – a barrier or instalment warrant for example.

Why have they proved popular elsewhere?

These products are traded on stock exchanges – not derivative exchanges – and as a result are often easier for brokers to offer their clients. Also private investors can trade them through their existing equity trading account.

Three points should be stressed here. Covered warrants can give investors exposure to an enormous range of underlyers, and all of these products are quoted in sterling.

These products can offer investors exposure over a long time horizon – listed options typically have maturities of 9 months or less whilst securitised derivatives can go out to 5 years plus. Contract sizes are smaller allowing lower minimum trade sizes.

Branded market

These products are ‘branded’ with the name of the issuing institution and hence private investors know who they’re trading with – if an investor considers that a specific institution has been pricing their products uncompetitively, they will know to take their custom elsewhere.

The other point to stress is that there is considerable price competition in these markets – although this occurs across multiple securities with similar characteristics (e.g. 30 different Vodafone warrants) rather than on one security like in the equity markets (e.g. Vodafone ordinary stock).

Investors can only buy covered warrants, and as such maximum losses are limited to the initial purchase price – unlike other leveraged products you cannot lose more than your initial investment.

What is the market model in the UK?

These products will be available through a number of UK private client brokers – both execution only and advisory. Investors will need to have signed a risk warning notice before starting to trade these products, and if your broker is providing advisory services they will need to have specific regulatory registrations (e.g. derivatives examinations).

The LSE has developed a two-tier structure for pricing and trading these products. Firstly, they have developed a new segment of their automated trading platform designed specifically for Securitised Derivatives – named the Covered Warrant Trading Service.

This segment provides a continuously priced trading environment where automatic order execution can take place against a committed principal (who is usually the issuer of the product as well).

Furthermore, products can be listed and traded outside of the order book in a quote-driven market against Retail Service Providers (these are either the issuers of the product or more typically another institution acting on behalf of the issuer).

Although complex, this model closely follows the current situation in the equity market where private client brokers typically use the order book for price dissemination purposes but tend to execute trades against RSPs in an effort to get price improvement and to minimise transaction costs.

The LSE will also impose obligations on participants looking to provide liquidity in these products – they have stated that all committed principals must conform to maximum spread and normal market size rules (committed principals must always offer a size of 10,000 to buy or sell).

Finally, it is worth noting that all securitised derivatives are dematerialised (i.e. investors cannot hold paper certificates) and they will be settled through CREST in the same fashion as equities.

How does this compare to other markets across Europe?

The UK aligns to the rest of Europe in having these products listed and traded on the domestic stock exchange (the LSE) and settled through the existing equity settlement system (CREST).

In Switzerland products are listed on the SWX and settled through SIS, in Germany they are listed on the regional exchanges such as Stuttgart and Frankfurt and settled through Clearstream, and in Italy listing is on the MCW segment of the Borsa in Italy and settlement takes place through Monte Titoli.

The differences between these various markets lie in the execution models that are in use. In Germany private clients can determine whether to route trades through an off-exchange quote-driven market or alternatively send them to one of the various floor-based regional exchanges that can accept limit orders.

In contrast the Italian and Swiss markets operate a full central limit order book where all client orders are sent directly to one central pool of liquidity.

Another point of reference is the typical time to market for launching a new warrant. The UK model suggests a timeframe of 24-48 hours making it one of the fastest in Europe.

The German market runs at a similar pace, whilst issuance in Switzerland and Italy typically takes over a week.

One of the potential constraining factors on the growth in the number of products issued in the UK will be the limited data bandwidth that will be available on the LSE’s CWTS platform at launch.

This is mitigated though by LSE plans to increase capacity through 2003 and the fact that issuers have the option of launching products off CWTS in a purely quotedriven environment where there is infinite capacity.

Nonetheless, we would assume that the number of products listed in the UK would be much smaller than Germany (30,754 in July), Italy (5,388) or Switzerland (4,424) to start with.

On the regulatory side the UK model is completely in line with European practices in requiring investors to sign a risk warning notice before entering into a trade.

Lastly, where might the demand for these products originate?

Again if we look to Europe most of the trading in Italy and Germany comes from a handful of large on-line discount brokers offering straight through trading to their clients at very low prices.

Switzerland on the other hand is far more fragmented and order flow comes from a range of execution only brokers, financial advisors, private banks and institutions.

It may be that the UK market resembles the Swiss model given the fragmented state of the brokerage sector and the greater emphasis on advisory and discretionary services relative to continental Europe.

In conclusion, the UK market looks to have taken the right approach by tailoring ‘best of breed’ practices from Europe to the inevitable idiosyncrasies of the existing UK private client model.

Goldman Sachs Europe
Peterborough Court
133 Fleet Street
London EC4A 2BB
Telephone: 0845 609 1555
Fax: 020 8552 8414
E-mail: ukwarrants@gs.com
Web: http://www.gs-warrants.co.uk

Entry Filed under: SUPPLIER AND TECHNOFIN®, Covered Warrants